Generating significant passive income through traditional approaches has posed a challenge in today’s investment environment. Following the emergence of the pandemic, interest rates have fallen and bond yields remain very low by historical standards, with the yield on 10-year US Treasuries hovering around 1.3%. Additionally, during the pandemic, many companies or funds that typically pay dividends had to cut back or take a break due to economic conditions. Rising inflation adds yet another obstacle to the search for yield, leaving most income investments firmly in negative interest rate territory once inflation is factored in. That’s enough to leave many investors, especially retirees and near-retirees, unsure of what to do.
One potential solution to consider is pass-through securities, which provide investors with access to specialized groups of publicly traded assets that are exempt from corporate tax. Because these securities are not taxed, almost all of their income must go to investors, which is why they are called “pass-through” securities. Profits are passed on to investors tax-free to avoid being taxed twice. This mechanism allows investors to benefit from income streams which may be higher than if they were subject to tax.
There are four types of pass-through securities, each offering exposure to different market sectors:
1. Real estate investment trusts (REITs). REITs are probably the most well-known pass-through security. These allow investors to access the real estate market without having to own or manage real property. REITs typically invest in either financing mortgage loans or owning physical properties (such as commercial buildings). In a REIT, 75% of the investments must be in real estate and 90% of the profits must be returned to investors to qualify for the exemption from corporation tax.
2. Master Limited Partnerships (MLP). MLPs are mostly companies structured as publicly traded partnerships, where investors serve as limited partners. To be considered an MLP, 90% of the company’s revenue must come from the energy or natural resource sectors. The advantage of being an MLP instead of a traditional business? MLPs do not have to pay income tax. The General Partner will manage the day-to-day operations, while the Limited Partners (investors) will provide the funding and therefore receive a portion of the profits.
3. Business Development Corporations (CASs). BDCs are publicly traded companies that invest in small and medium-sized businesses to help them grow, normally through money lending. Created by Congress in 1980, their goal is to stimulate job growth and support new businesses. BDCs must invest at least 70% of their assets in private or public US companies with market capitalizations of less than $ 250 million. It is the smallest group of pass-through securities, with 48 listed on the public market.
4. Closed-end funds (FEC). CEFs are listed with an initial public offering (IPO) and structured in the same way as a mutual fund, except that a CEF has a fixed share capital, whereas a mutual fund can have investors and unlimited capital. For a CEF, the amount of capital raised for the IPO is the amount that the fund manager must invest. Investors then buy and sell the set amount of shares in the stock market, with the price fluctuating depending on the value of the fund, as well as the supply and demand of shares.
Since pass-through securities are publicly traded, adding them to a portfolio is as easy as buying a traditional stock. One way to manage the risks associated with picking or selecting individual intermediary securities to hold is to invest in all four categories.
Currently, the traditional investment market is too unreliable to depend solely on it for stable returns. Anyone who invests to generate living income can find a solution in pass-through securities.
Does Rhind is the Founder and CEO of GraniteShares, an ETF investment firm focused on providing investors with innovative and cutting edge investment solutions. The GraniteShares HIPS US High-Income ETF (HIPS) is an exchange-traded fund that provides exposure to REITs, MLP, BDC and CEF. The HIPS ETF seeks to pay a monthly distribution. The fund has a current distribution rate of 8.34% (as of 09/24/2021; distributions are not guaranteed) per year. Investors should carefully consider investment objectives, risks, fees and expenses before investing. To obtain a prospectus or summary prospectus containing this and other information about the GraniteShares ETF HIPS, please call (844) 476-8747 or visit www.graniteshares.com/etfs. Read the prospectus or summary prospectus carefully before investing.